Fire Sales, Foreign Entry and Bank Liquidity1

Bank liquidity is a crucial determinant of the severity of banking crises. In this paper, we consider the e¤ect of …re sales and foreign entry on banks’ex ante choice of liquid asset holdings, and the ex post resolution of crises. In a setting with limited pledgeability of risky cash ‡ows and di¤erential expertise between banks and outsiders in employing banking assets, the market for assets clears only at …re-sale prices following the onset of a crisis – and outsiders may enter the market if prices fall su¢ ciently low. While …re sales make it attractive for banks to hold liquid assets, foreign entry reduces this incentive. We exhibit international evidence on foreign entry following crises and on banks’ex ante liquidity choice that are consistent with the predictions of the model. Our framework allows us to address the key welfare question as to when there is too much or too little liquidity on bank balance sheets relative to the socially optimal level. J.E.L. Classi…cation: G21, G28, G32, E58, D61